Lower Rates Fuel

The 2 biggest factors for corporate earnings are economic growth and ........ interest rates.  Most investors focus on economic growth and usually don't pay much attention to interest rates, because it works more subtly and with a lag.  Also historically, economic growth was more volatile than interest rates, making it a much more important factor in determining stock prices.

However, since 2008, economic growth has been stable, but low. The business cycle has become the business flat line. Economic growth used to be a variable.  Now it is basically a constant.  That is what happens when you have a battle between downward forces of demographics/lack of productivity growth versus upward forces to growth from big tax cuts and deficit spending and a hyper proactive Fed looking to rescue financial markets with a firehose of liquidity at the slightest hint of a slowdown.


Since 2008, other than Fed funds rates, the yield 5+ years out have been erratic.  In 2009, with ZIRP, the 10 year yield was as high as 3.90%.  In 2012, with the same ZIRP, the 10 year yield went downt to 1.40%.  And then up as high as 3.00% in 2013.  And then back down to 1.32% in 2016.  All while Fed funds rate was below 50 bps.

It is no longer economic growth that is most important factor determining stock prices.  It is corporate welfare/regulatory capture and interest rates that are the biggest drivers.  The 2 biggest catalysts for stocks in the last 10 years has been QEs and tax cuts.  Those aren't organic growth factors.  They are policy driven factors that have diminishing returns and limitations.  The Fed cannot buy up all the Treasuries and MBS issued.  Nor can the tax rate go to zero.

With  trillion dollar deficits happening during the peak of an expansion, that tells you all that you need to know about the long term sustainability of current tax rates.  This huge deficit, which puts an upward pressure on interest rates, has to be countered with loose monetary policy to maintain the expansion.  Basically, the US will have to follow Japan and monetize its debt to keep growth where it wants it to be.

The bond market is sensing that the long term sustainable interest rate is much lower than current Fed funds rate given the weakening leading indicators, and the change in Powell's reaction function towards financial markets, specifically, the SPX.  Jerome Powell is now in Bazooka Ben mode.  If stocks goes up, talk dovish.  If stocks stays flat or go down, act dovish, i.e., cut or do QE.

The declining Treasury yields in May due to the above mentioned factors was the fuel that the stock market needed to come back this month, once the weak hands sold.  But a lot of this fuel has been used up, as the 10 year is nearing 2%.

In other words, stocks currently need the 10 year yield at 2.15% to maintain SPX 2880.  Previously in the fall of 2018, stocks could maintain SPX 2880 with a 10 year yield above 3.00%.  It is taking lower and lower interest rates to maintain current stock valuations.  This can't go on forever.  The stock market is the gas guzzling Land Rover.  Lower interest rates are the fuel.  If the Fed doesn't deliver with easy money soon, the stock market will have a panic attack.  Just like December 2018.  I do expect Jerome Powell to deliver the goods, giving the market what it wants, having learned his lesson in December about fighting dovish market expectations.  But he's a bit less predictable than Bernanke, so there is a slim chance he could trigger another rush to the exits for stock traders.

One thing is clear though.  Whatever Powell does in June or July meetings, the financial markets now have him by the balls, at their mercy.  He will have to be their slave, or else.

Bonds are Saving the Stock Market

With all the negative news flow and deteriorating fundamentals, the main reason stocks didn't selloff more in May was because of risk parity.  Bonds acted as a super hedge for stocks, earning yield and rallying huge, providing a downside buffer for stocks.  Most investors own both fixed income and equities, so their whole portfolio determines their wealth, so their wealth didn't take much of a hit even with equities going down in May, because of the strong bond rally.  And that means less nervousness, less forced selling, and a support for the stock market. 

When you see bonds barely moving while stocks are getting hammered like October 2018, that sets up a carnage like you saw in December 2018.  It is also why the stock market rally in the first 4 months of the year was so strong.  Usually when stocks go up 20%, bonds are getting crushed, dampening some of the wealth effect.  But not this year.  Bonds have been strong, regardless of equity strength, providing a double boost for investors' portfolios. 

The market is now pricing in 100 bps in rate cuts for the next 18 months.  That seems priced about right, given the current economic situation and the Fed's historical tendency to panic when there is even a hint of a slowdown. 

Unfortunately for the stock market, a lot of bond market rally fuel has been used up to helps stocks in the past month.  Which means that even if the Fed cuts a few times in the next year, its not going to have much of a stimulative effect. 

That makes it all the more attractive to put on a SPX short position on any kind of positive trade news.  Because that would probably delay the Fed rate cuts, which are much more important for the market.  So in an odd way, that would be more bearish for stocks.  It could just be delays in China tariffs and the market will absolutely love it, giving it hope of a future trade deal. 

At this point, the bar for China tariff delay is very low, the bar for a trade deal is very high, and would require the SPX to get to at least 2650 before it catches the attention of Trump and his administration, where they start lowering demands from China to get a deal. 

China tariff delays are going to be the new China trade deal. 

It is short squeeze mode, and it has been a face ripper.  With the weak nonfarm payrolls report, that is a positive for stocks.  It just means bond yields will stay low even if stocks go up.  Great short term news for stocks. 

Return of the Lawn Chair(man)

Powell folded again.  That shouldn't be much of a surprise to those who learn from experience and recent history.  Those who learn by reading Bloomberg, WSJ, and CNBC, well, they were probably a bit surprised.  A weaker SPX, a raging bond market, and the Fed will follow the markets, or else.  And Powell isn't dumb enough to challenge the markets again, after his December experience.

Interest rate hikes work with lagged effects, as corporations gradually have to reissue debt and renew loans at higher yields.  Since rate hikes happened over a 2 year span from 2017 to 2018, they will start having maximum effect this year.  Add to that the fading fiscal stimulus from 2018, a US equity market that is probably in the top 5% in valuation in its history, and you have a powder keg that is about to blow up. 

No, a move from SPX 2950 to 2730 is not blowing.  I am talking a move down to 2100 over the next 18 months.  I choose 18 months because that is how much time there is left till the next US Presidential election.  If the economy weakens over the next year like most leading indicators are suggesting, that will put the nail in the coffin for Trump's chances at getting re-elected.  Again, that is what history and experience suggests.  The last 2 U.S. presidents that failed to get re-elected were Jimmy Carter in 1980 (bad economy) and George Bush Sr. in 1992 (coming out of a bad economy in 1991). 

Trade deal or no trade deal, the US economy will follow Europe, Japan, and the emerging markets into slowdown.  Today's ADP number is just another piece of evidence, after the weaker ISM and PMI numbers.  The bond market has been sniffing this out for the past month, and has gone into overdrive in a bond short seller seek and destroy mission. 

We are in one those rare, exquisite moments for an equity short seller where the risk/reward is absurdly good.  With all the clues that the leading indicators, valuations, and the bond market are giving, it is a no brainer to short the Fed rate cut rally.  And that is what yesterday was.  A realization that Powell is more dovish than what his underlings have said over the past few weeks, many who have been in denial about the Fed having to cut rates. 

The Fed is always reactive when entering the rate cut cycle, but with financial economy essentially the only dynamic part of the whole global economy, their lag times compared to past cycles (2000, 2007) will be less, and I fully expect Powell to either cut 25 bps in June meeting (if SPX is under 2750), or signal that a rate cut is coming very soon (if SPX is over 2800).  Between 2750-2800, he could go either way. 

In either case, that will provide the last sparks to an oversold short covering rally which started yesterday.  If things go according to plan, that should set up a good long term shorting opportunity in early/mid July.  May was just a small preview of things to come.  September and October will be the main event.